Why hotel loans are different than other real estate loans -- A quick review
Hotel lending involves more lending to an operating business than lending to an owner of most types of commercial real property. Unlike typical real estate, hotel revenues are cyclical and not fixed. In fact, hotel revenues change daily. (That can be good news, as hotels can be a solid inflation hedge.) An experienced hotel lender will structure its loan with hotel-related loan covenants consistent with the hotel's operating results, so that loan payments will more closely match the fluctuating and cyclical nature of hotel revenues.
Further, because the hotel is an operating business, the hotel will succeed or fail by the actions and inactions of the hotel management team. Running a hotel is much more difficult than running a traditional real estate project. Because many lenders handle their hotel lending out of their real estate lending department, they often make the mistake of twisting their real estate secured loan documents to include hotel lending provisions. This is always a mistake. We have to remind these lenders that "You don't know what you don't know" when it comes to hotel lending. Hotel loans need to be in the hands of legal and business hotel specialists.
Because the operating business of the hotel represents at least half the value of the hotel, the hotel lender has to be tuned into issues that arise in the running of the hotel. Such issues include hotel projected revenues and expenses, marketing, trade credit, capital and operating costs, revenue enhancement and cost containment, employment and unions, ADA compliance, labor and employment, branding, back-end systems, and so forth.
Any good commercial real estate lender will plan for an exit strategy in the event the borrower should default. For the hotel lender, this means it must be prepared to own and run a hotel.
Understanding the impact on your loan of hotel management agreements and hotel franchise agreements
Hotel management and branding are keys to a successful hotel. The hotel lender has to understand thoroughly the hotel management and franchise arrangements. An experienced hotel lender will be well aware that the hotel and franchise agreements carry significant obligations, burdens and requirements on the hotel owner's part. The hotel lender must confirm that the hotel owner has the financial resources and experience to comply with them.
The hotel lender also needs to understand the other costs associated with the hotel management and franchise agreements, how these issues impact the value of its collateral, and how these agreements impact its rights and remedies as a hotel lender.
For example, such arrangements will have a significant cost structure, including a requirement that the hotel owner pay a variety of fees beyond the base fee, such as incentive fees, marketing fees, centralized system fees, consulting fees, and so forth. This fee structure can often be three or four times the base fee amount. This is why the hotel lender needs to take a systematic approach to reviewing the hotel and the hotel operating documents. The documents should answer the following critical questions:
- Is the hotel operator the right hotel management or franchise company for this project? How was this decision made? What are the rights of the hotel lender to change these circumstances if a wrong decision was made?
- Does the hotel lender have the right to receive copies of key communications between the hotel owner and management, budgets, reports, projections, business plans, marketing plans and operating plans? Does the lender have the right to require such financial information and other information in a form acceptable to it? Does the hotel lender have the experience to understand these key communications and indicators within them?
- Does the hotel lender have approval rights over the hotel operator (particularly with independent third party operators) and key members of its executive staff, the number of employees and any changes in hotel positioning and amenities?
- Can the lender freely terminate a hotel management agreement on foreclosure (or deed in lieu)? If not, will the brand's long-term, no-cut management contract discourage a high percentage of potential buyers for the hotel or reduce its sales price, and has the lender accounted for this in its underwriting?
- Does the lender understand the specific duties of the hotel operator, and does the hotel lender have enforcement rights under the hotel documents?
- Is the hotel lender senior -- or is it actually junior -- under the Subordination, Non-Disturbance and Attornment Agreement (SNDA)? And what are the lender's obligations under the SNDA? With the typical hotel SNDA, the right hand taketh what the left hand appear to giveth the lender. These obligations can be extremely costly, and may not be obvious to an inexperienced eye when reviewing the SNDA. (The SNDA is addressed in a separate article in this "What every hotel lender should know" series.)
- Have the elements of fiduciary protections been built into the hotel documents?
- If the hotel owner owes money to the hotel operator, franchisor or even third party contractors or vendors, will the hotel lender ultimately get stuck with paying the bill?
- What impact does an owner filing for bankruptcy have on the hotel lender's rights vis-a-vis the hotel operator and the hotel management agreement? And what steps can the hotel lender take up front to protect its rights?
Experienced hotel lenders and knowledgeable hotel lawyers and advisors, will dig deeply into the hotel management or franchise agreement to find the answers to these questions. The answers may lead to more questions but, ultimately, the lender must be satisfied that it understands all the ways in which these documents affect its rights and obligations.
Hotel lending lawyer series - What every hotel lender needs to know
There are a lot of hotel-specific issues that hotel loan documents have to deal with. This series is designed to provide the essentials: